Theoretical Review of IS-LM Model - Case Study Example

IS-LM MODEL Student’s Name Subject Professor University/Institution Location 1.0. Executive summary The report covers the theoretical review of IS-LM model. It covers the introduction, the equilibrium in the money and commodity markets. The impact of the monetary policy instruments such as increase in money supply on ISLM model. Finally, the limitations and conclusion on IS-LM is made. 1.1. Theoretical review: IS-LM Model 1.2. Introduction The IS-LM model requires the interaction of the commodity and money markets. The equilibrium in the money market LM is equated to the equilibrium in the goods market to obtain the general equilibrium of IS-LM model. 1.3. Equilibrium in the commodity market Investment [I(r) = γ − δr] depends negatively on interest rates due to present value explanations. A decrease in interest rates results to a rise in investment which in turn causes a multiple expansion in income. In the commodity market, the Keynesian consumption function is utilized as depicted in equation 1; C(Y, T) = α + β(Y − T) 0 < β < 1, α > 0 (1) T (Y) = ξ + Τy 0 < τ < 1 (2) I(r) = γ– δr (3 G=GO (4) The direct government expenditure is treated as an exogenous variable. The equilibrium in the goods market is obtained by summing up equations 1, 3 and 4 into as shown in equation 5: Y = C(Y, T) + G + I(r) (5) But, C(Y, T) = α + β(Y − T) = α + β (Y - ξ – Τy) And I(r) = γ – δr Therefore, Y = α + β(Y - ξ – Τy) + G + γ − δr Making Y the subject; Y = α/ (1−β) - βξ/(1−β) – βΤy/(1−β) + G/(1−β) + γ/(1−β) − δr/(1−β) (6) Where; Y, C, T, G, r and I are income, consumption, tax, government expenditure, official interest rate and investment, respectively. γ, α, δ and β parameters representing autonomous investment, autonomous consumption, induced investment and marginal propensity to consume, respectively. 1.4. Graphical depiction of the IS Curve Figure 1.4 IS curve graphical depiction. The slope of the IS curve depicts the impact of the rate of interest on investment that results to multiplier effect which increases income. The location of the IS curve changes depending on the components of the aggregate demand such as autonomous investment, marginal propensity to consume or fiscal policy. 2.0. The equilibrium in the money market The money market attains equilibrium when the demand for money equals the supply of money. According to the Keynesian theory, people require money for transaction and speculative purposes. The transaction demand for money is an increasing function of income. The amount of money an individual holds depends on the prevailing interest rates in the market. The interest rate is the cost of holding money. An individual has to choose between having idle cash balances that does not earn interest and investing in other financial assets that earn interest. There is a negative relationship between interest rates and investment in lending or purchase of financial assets. Equation 7 shows the demand for money. Money demand = ω + λY – ψr (7) Where; ω + λY show the transaction demand for money that is dependent on income and ψr is the speculative demand for money which is dependent on the rate of interest. The supply of money is determined exogenously. The government and the monetary authority determine the amount of money in circulation in the economy. Equation 8 shows the supply of money; Real Money supply (M/P) = L(Y, r) (8) Where; Y is income and r is the official interest rate. The demand for money or demand for liquidity equals the real supply of money when the money market attains equilibrium. Equating equation 7 and equation 8 gives equilibrium in the money market as shown in equation 9; L(Y, r) = ω + λY – ψr Making interest rate the subject; Y = L(Y, r)/ λ - ω/λ + ψr/ λ (9) 2.1. Graphical presentation of LM. Figure 2.1 The slope of LM depicts interest and income elasticity of money demand 3.0. The general equilibrium of IS-LM Model The general equilibrium is obtained by equating the equilibrium in the goods market to equilibrium in the money market. Combining equation 9 and equation 6 gives the general equilibrium in the IS-LM model as shown in equation 8. L(Y, r)/ λ - ω/λ + ψr/ λ = α/ (1−β) - βξ/ (1−β) – βΤy/ (1−β) + G/(1−β) + γ/(1−β) − δr/(1−β) ψr/ λ + δr/(1−β) = α/ (1−β) - βξ/ (1−β) – βΤy/ (1−β) + G/(1−β) + γ/(1−β) - L(Y, r)/ λ + ω/λ r = α/ (1−β) [ψ / λ + δ/ (1−β)] - βξ/ (1−β) [ψ / λ + δ/(1−β)] – βΤy/ (1−β) [ψ / λ + δ/(1−β)] + G/(1−β) [ψ / λ + δ/(1−β)] + γ/(1−β) [ψ / λ + δ/(1−β)] - L(Y, r)/ λ + ω/λ[ψ / λ + δ/(1−β)] (10) 3.1. Graphically IS-LM combined Equilibrium for the real and money markets is attained when the LM intersects with the IS curve. As a result, interest rate and those things that rely on interest as well as income and those things that rely on income, are endogenous. Figure 3.1 3.2. Effects of Monetary Policy on IS-LM Model An increase in money supply through expansionary monetary policy, shifts LM curve to the right (LM0 to LM1) lowers interest rates (the new equilibrium point is E1 from E0 ) while raising income as shown in fig. 3.2. The multiplier effect results to increased consumption as income increases and at lower interest rates, investment increases. Figure 3.2 3.3. Policy mix The monetary policy and the fiscal policy can interact through employing a policy mix. The monetary authority can reduce interest rates without a reduction on income. For instance, when there is crowding out effect and the LM curve is vertical. The government would employ a monetary policy that reduces the rate of interest rates such as reducing the lending rates and to increase the supply of money in the economy, it could have tax cuts and increase government spending. The shift in IS curve downwards effectively reduces interest rates. 3.4. Assumptions of the model The model does not take into account the aggregate supply side. It applies the business cycle assumption of constant price. In the IS-LM model, the rest of the world is ignored as it assumes a closed economy; the country has zero exports and zero imports. The model requires at least two financial assets in the money market such as money and bonds for there to be an opportunity cost. For instance, an individual has to choose between money and bonds. Money is safe, liquid and has zero returns when an individual hoards it. On the other hand, bonds are capable of earning interest; they are risky and are illiquid. It assumes that when the money market clears, the bond markets will clear too implying that ignore the money market when the bond market clears because when the money market clears the bond market clears too. 3.5. Limitations of the model The model does not comprehensively tackle the economic effects of banks’ decision on interest rates because of its assumptions. For instance, the model assumes constant price which is not realistic. In addition, the persistent increase in price overtime is known to cause inflation. Banks are opening overseas subsidiaries and countries have a balance of payments which makes the assumption of autarky unreasonable. 3.6. Conclusion The model has limitations that limit its capability in offering economic fundamentals in the dynamic global economy. The model could be adjusted to suit an open economy and have an extension to cater for the international capital markets that offer complex financial products. References Asteriou, Dimitrios, and Stephen G. Hall. Applied econometrics. New York: Palgrave Macmillan, 2011. Chiarella, Carl, and Peter Flaschel. The dynamics of Keynesian monetary growth. Cambridge University Press, 2010 Friedman, Benjamin M. The LM Curve: A Not-so-Fond Farwell. Cambridge, Mass: National Bureau of Economic Research, 2003. Leeson, Robert. The Keynesian Tradition. Houndmills, Basingstoke: Palgrave Macmillan, 2008. Romer, David. Keynesian Macroeconomics Without the LM Curve. Cambridge, MA: National Bureau of Economic Research, 2000. Snowdon, Brian, and Howard R. Vane. An Encyclopedia of Macroeconomics. Cheltenham, UK: E. Elgar, 2002. Vroey, Michel de, and Kevin D. Hoover. The IS-LM Model: Its Rise, Fall, and Strange Persistence. Durham, N.C.: Duke University Press, 2004. Young, Warren, and Benzion Zilberfarb. IS-LM and Modern Macroeconomics. Boston: Kluwer Academic Publishers, 2000. . Read More